One of the risks of being an income investor is that you can be seduced by attractive yields, which are sometimes a symptom of a declining business or a falling share price.
Take Wm. Morrison Supermarkets (LSE: MRW) (NASDAQOTH: MRWSY.US), for example. The firm’s 4.9% prospective yield is very attractive, but 4.9% is substantially less than the long-term average total return from UK equities, which is about 8%.
Morrisons’ share price has risen by just 3% so far this year, underperforming the FTSE 100’s 11% gain. If Morrisons’ share price continues to underperform, the returns provided by its generous dividend could be eroded by capital losses.
What will Morrisons’ total return be?
Looking ahead, I need to know the expected total return (capital gains plus dividends) from Morrisons shares, so that I can compare them to my benchmark, a FTSE 100 tracker.
The dividend discount model is a technique that’s widely used to value dividend-paying shares. A variation of this model also allows you to calculate the expected rate of return on a dividend-paying share:
Total return = (Prospective dividend ÷ current share price) + expected dividend growth rate
Here’s how this formula looks for Morrisons:
(12.9 ÷ 266) + 0.09 = 0.138 x 100 = 13.8%
My model suggests that Morrisons shares could deliver a 13.8% annual total return over the next few years, healthily outperforming the long-term average total return of 8% per year I’d expect from a FTSE 100 tracker.
Isn’t this too simple?
One limitation of this formula is that it doesn’t tell you whether a company can afford to keep paying and growing its dividend.
My preferred measure of dividend affordability is free cash flow — the operating cash flow that’s left after capital expenditure, tax costs and interest payments.
Free cash flow = operating cash flow – tax – capital expenditure – net interest
Morrisons’ expansion into convenience stores and online is absorbing most of the firm’s free cash at the moment, and last year’s free cash flow of £96m was not enough to cover the firm’s £270m dividend payout.
However, Morrisons’ debt levels remain in-line with those of Tesco and J Sainsbury, and the firm expects capex to peak at around £1.2bn in 2013/14, before falling back to £850m in 2014/15, and then to a long-term rate of around £650m, which should improve free cash flow.